SUGGESTED ANSWERS - Group 1 Costing (Code FUN) Computation of Effective Cost of Factoring

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1 SUGGESTED ANSWERS - Group 1 Costing (Code FUN) Disclaimer (Read carefully) The answers given below are prepared by the faculty of Samvit Academy as per their views and experience. The working notes, notes and assumptions, if any stated, are purely the views of the respective faculty of Samvit Academy and students are encouraged to go through them and apply the same in the examination as a good practice. No assurance is given that the answer keys of the Institute of Chartered Accountants of India used for valuation are the same. However, utmost care has been taken while designing the below suggested answers. Feedback is welcome. For the questions, please refer to the question paper. Question 1 (a) Computation of Effective Cost of Factoring Average level of Receivables = 12,00,000 * 90/360 3,00,000 Factoring Commission = 3,00,000 * 2/100 6,000 Factoring Reserve = 3,00,000 * 10/100 30,000 Amount Available for Advance = Rs. 3,00,000-(6,000+30,000) 2,64,000 Factor will deduct his 16% :- Interest = *90/360*16% = Advance to be paid = Rs. 2,64,000 Rs. 10,560 = Rs. 2,53,440 Annual Cost of Factoring to the Firm: Rs. Factoring Commission (Rs. 6,000 * 360/90) 24,000 Interest Charges (Rs. 10,560 *360/90) 42,240 Total 66,240 Firm s Savings on taking Factoring Service: Rs. Cost of Administration Saved 50,000 Cost of Bad Debts (Rs. 12,00,000 x 1.5/100) avoided 18,000 Total 68,000 Net Benefit to the Firm (Rs. 68,000 Rs. 66,240) 1760 Effective Cost of Factoring =66240*100/ % Effective Cost of Factoring = %

2 (b) Purchase price = 25,000 Loan amount = = Rate of interest = 14%/12 = % p.m Loan = Installment*Annuity factor 20,000 = Installment*AF(1.1667,24) 20,000 = Installment* (i) Installment =20000/ = (ii) Total interest paid = Installments paid - loan = * = (c) Types of Fiscal Policy : Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction. This is accomplished by increasing aggregate expenditures and aggregate demand through an increase in all types of government spending and / or a decrease in taxes. Contractionary fiscal policy is basically the opposite of expansionary fiscal policy. Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy during an inflationary phase or when there is anticipation of a business-cycle expansion which is likely to induce inflation. This is carried out by decreasing the aggregate expenditures and aggregate demand through a decrease in all types of government spending and/ or an increase in taxes. Contractionary fiscal policy should ideally lead to a smaller government budget deficit or a larger budget surplus. In other words, if the state of the economy is such that its growth rate is extraordinarily high causing inflation and asset bubbles, contractionary fiscal policy can be used to confine it into sustainable levels (d) Income Method : GDP MP = Employee compensation (wages and salaries + employers' contribution towards social security schemes) + profits + rent + interest + mixed income + depreciation + net indirect taxes (Indirect taxes - subsidies) GDP MP = 6, , = 10,890 GNP MP = GDP MP + NFIA =10, =10,930 Expenditure Method : Y = C + I + G + (X M) Y = ( ) GDP MP = 10,890 GNP MP = 10, = 10,930

3 Question 2 (a) 1 Computation of Net Present Values of Projects Year Cash flows Disct. Discounted Cash flow Project A (Rs ) Project B (Rs ) 16 Project A (Rs ) % Project B (Rs ) (1) (2) (3) (3) (1) (3) (2) 0 (1,35,000) (2,40,000) (1,35,000) (2,40,000) , , ,000 84, ,290 62, ,32,000 96, ,612 61, ,000 1,02, ,368 56, ,000 90, ,984 42,840 Net present value 58,254 34,812 2 Computation of Cumulative Present Values of Projects Cash inflows Year Project A Project B PV of cash inflows (Rs) Cumulative PV (Rs) PV of cash inflows (Rs) Cumulative PV (Rs) ,720 51, ,290 22,290 62,412 1,14, ,612 1,06,902 61,536 1,75, ,368 1,53,270 56,304 2,31, ,984 1,93,254 42,840 2,74,812 (i) Discounted payback period: (Refer to Working note 2) Cost of Project A = Rs 1,35,000 Cost of Project B = Rs 2,40,000 Cumulative PV of cash inflows of Project A after 4 years = Rs 1,53,270 Cumulative PV of cash inflows of Project B after 5 years = Rs 2,74,812 comparison of projects cost with their cumulative PV clearly shows that the project A s cost will be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of discounted payback period can be computed as follows: Excess PV of cash inflows over the project cost (Rs) Computation of period required to recover excess amount of cumulative PV over project cost (Refer to Working note 2) Discounted payback period Project A 18,270 (Rs 1,53,270 - Rs 1,35,000) 0.39 year (Rs 18,270 Rs 46,368) 3.61 year (4-0.39) years (i) Profitability Index(PI): Sum of discounted cash inflows = Initian cash outlay Profitability Index (for Project A) =1,93,254/1,35,000 =1.43 Project B 34,812 (Rs 2,74,812 - Rs 2,40,000) 0.81 years (Rs 34,812 Rs 42,840) 4.19 years (5-0.81) years

4 Profitability Index (for Project B) =2,74,812/ 2,40,000 = 1.15 (ii) Net present value(npv) (for Project A) = Rs 58,254 Net present value(npv) (for Project B) = Rs 34,812 (Refer to Working note 1) Conclusion: As the NPV, PI of Project A is higher and Discounted Pay back is lower, therefore Project a should be accepted. (b) Externalities : Costs or benefits which are not accounted for by the market price are called externalities because they are external to the market. In other words, there is an externality when a consumption or production activity has an indirect effect on other s consumption or production activities and such effects are not reflected directly in market prices. Externalities are also referred to as 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the originator of the externality imposes costs or benefits on others who are not responsible for initiating the effect. Externalities may be unidirectional or reciprocal. Suppose a workshop creates earsplitting noise and imposes an externality on a baker who produces smoke and disturbs the workers in the workshop, then this is a case of reciprocal externality. If an accountant who is disturbed by loud music but has not imposed any externality on the singers, then the externality is unidirectional. Externalities can be positive or negative. Negative externalities occur when the action of one party imposes costs on another party. Positive externalities occur when the action of one party confers benefits on another party. The four possible types of externalities are: Negative production externalities : A negative externality initiated in production which imposes an external cost on others may be received by another in consumption or in production. As an example, a negative production externality occurs when a factory which produces aluminum discharges untreated waste water into a nearby river and pollutes the water causing health hazards for people who use the water for drinking and bathing. Pollution of river also affects fish output as there will be less catch for fishermen due to loss of fish resources. The former is a case where a negative production externality is received in consumption and the latter presents a case of a negative production externality received in production. There is no market in which these external costs can be reflected in the price of aluminum Positive production externalities : A positive production externality initiated in production that confers external benefits on others may be received in production or in consumption. As an example of positive production externality received in production, we can cite the case of a firm which offers training to its employees for increasing their skills. The firm generates positive benefits on other firms when they hire such workers as they change their jobs. Another example is the case of a beekeeper who locates beehives in an orange growing area enhancing the chances of greater production of oranges through increased pollination. A positive production externality is received in consumption when an individual raises an attractive garden and the persons walking by enjoy

5 the garden. These external effects were not in fact taken into account when the production decisions were made. Negative consumption externalities : Negative consumption externalities initiated in consumption which produce external costs on others may be received in consumption or in production. Examples is the smoking of cigarettes in public place causing passive smoking by others, creating litter and diminishing the aesthetic value of the room and playing the radio loudly obstructing one from enjoying a concert. The act of undisciplined students talking and creating disturbance in a class preventing teachers from making effective instruction and the case of excessive consumption of alcohol causing impairment in efficiency for work and production are instances of negative consumption externalities affecting production. Positive consumption externalities : A positive consumption externality initiated in consumption that confers external benefits on others may be received in consumption or in production. For example, if people get immunized against contagious diseases, they would confer a social benefit to others as well by preventing others from getting infected. Consumption of the services of a health club by the employees of a firm would result in an external benefit to the firm in the form of increased efficiency and productivity Question 3: (a) Walter s model is given by P = D + (E-D)(r/Ke) Ke Where, P = Market price per share, E = Earnings per share = Rs20,00,000 4,00,000 = Rs 5 D = Dividend per share = 60% of 5 = Rs 3 r = Return earned on investment = 15% Ke = Cost of equity capital = 12% 3 + (5-3)*0.15 = 0.12 = According to Walter s model when the return on investment is more than the cost of equity capital, the price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in this case is Nil. So, at a payout ratio of zero, the market value of the company s share will be:- 0 + (5-0)*0.15 = 0.12 =

6 (b) Borrowing option: Annual Instalment = Rs5,00,000/ 5 = Rs1,00,000/- Annual depreciation = Rs5,00,000/ 5 = Rs1,00,000/- Computation of net cash outflow: Year Principal (Rs) (Rs) Total (Rs) Tax Saving on Net cash Depreciation. & Interest Outflow (Rs) (Rs) 1 1,00,000 50,000 1,50,000 45,000 (30% of 1,50,000) 2 1,00,000 40,000 1,40,000 42,000 (30% of 1,40,000) 3 1,00,000 30,000 1,30,000 39,000 (30% of 1,30,000) 4 1,00,000 20,000 1,20,000 36,000 (30% of 1,20,000) 5 1,00,000 10,000 1,10,000 33,000 (30% of 1,10,000) 8% Total PV (Rs) 1,05, ,230 98, ,986 91, ,254 84, ,740 77, ,437 3,67,647 Less: Present value of Inflows at the end of 5 th year (Rs 50, ) or Rs 35, = PV of Net Cash outflows 23,835 3,43,812 Calculation of lease rentals: Therefore, Required Annual after tax outflow = Rs 3,43,812/3.993 = Rs 86,104/- Therefore, Annual lease rental = Rs 86,104/0.70 = Rs 1,23,006/- (c) Advantages of Electronic Cash Management System (i) Significant saving in time. (ii) Decrease in interest costs. (iii) Less paper work. (iv) Greater accounting accuracy. (v) More control over time and funds. (vi) Supports electronic payments. (vii) Faster transfer of funds from one location to another, where required. (viii) Speedy conversion of various instruments into cash. (ix) Making available funds wherever required, whenever required. (x) Reduction in the amount of idle float to the maximum possible extent

7 (d) Personal Income is the income received by the household sector including 'Non-Profit Institutions serving Households'. National income is a measure of income earned and personal income is a measure of actual current income receipts of persons from all sources which may or may not be earned from productive activities during a given period of time. In other words, it is the income actually paid out to the household sector, but not necessarily earned. Examples of this include transfer payments such as social security benefits, unemployment compensation etc. PI = NI + income received but not earned income earned but not received. Disposable personal income is a measure of amount of the money in the hands of the individuals that is available for their consumption or savings. DI = PI - direct taxes - any other compulsory payments made to the government DI = PI - Personal Income taxes Question 4 (a) Particulars 1,00,000 units 1,20,000 units Sales at Rs 10 per unit 10,00,000 12,00,000 Less: Variable costs at Rs 6 per unit 6,00,000 7,20,000 Contribution (C) at Rs 4 per unit 4,00,000 4,80,000 Less: Fixed expenses 2,00,000 2,00,000 Operating Profit or EBIT 2,00,000 2,80,000 Less Interest on Debentures (10% on Rs 10 Lakhs) 1,00,000 1,00,000 Profit before tax (PBT) 1,00,000 1,80,000 Less Tax at 50% 50,000 90,000 Profit after tax (PAT) or net profit 50,000 90,000 (i) Earnings per Share (EPS) [10,000 equity shares] 5 9 % increase in EPS 9-5/5 *100 = 80% (ii) Financial leverage EBIT/PBT (iii) Operating leverage Contribution/EBIT

8 (iv) In relation to increase in Production & Sales of 1,00,000 units to 1,20,000 units (20% increase), EPS has gone from Rs 5 to Rs 9 i.e. increased by 80%. But both the Financial Leverage and Operating Leverage have decreased with increase in sales. Due to this reduction, both the risks i.e. business risk & financial risks of the business are reduced. (b) Venture Capital Financing and Factors to be considered in financing any Risky Project Under venture capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success. The factors to be considered in financing any risky project are: (i) Quality of the management team is a very important factor to be considered. They are required to show a high level of commitment to the project. (ii) The technical ability of the team is also vital. They should be able to develop and produce a new product / service. (iii) Technical feasibility of the new product / service should be considered. (iv) Since the risk involved in investing in the company is quite high, venture capitalists should ensure that the prospects for future profits compensate for the risk. (v) A research must be carried out to ensure that there is a market for the new product. (vi) The venture capitalist himself should have the capacity to bear risk or loss, if the project fails. (vii) The venture capitalist should try to establish a number of exit routes. (viii) In case of companies, venture capitalist can seek for a place on the Board of Directors to have a say on all significant matters affecting the business. (Note: Students may answer any two of the above factors) (c) There is no unique definition of money. Money can be defined for policy purposes as the set of liquid financial assets, the variation in the stock of which could impact on aggregate economic activity. As a statistical concept, money could include certain liquid liabilities of a particular set of financial intermediaries or other issuers Money has the following few characteristics - It is : generally acceptable

9 durable or long-lasting effortlessly recognizable. difficult to counterfeit i.e. not easily reproducible by people relatively scarce, but has elasticity of supply portable or easily transported possessing uniformity; and divisible into smaller parts in usable quantities or fractions without losing value The supply of money in the economy depends on: the decision of the central bank which is the primary source of money supply in all countries. The currency issued by the central bank is fiat money the supply responses of the commercial banking system of the country. Banks create money supply in the process of borrowing and lending transactions with the public. Money so created by the commercial banks is called 'credit money Question 5 (a) ROE = [ROI + {(ROI r) x D/E}] (1 t) = [ {( ) x 0.60}] (1 0.40) = [ ] x 0.60 = ROE = 15.60% (b) Rs Crs Option 1 Option 2 Option 3 Equity shares Loan@15% Pref shares@12% EBIT Int 30*15% EBT Tax@30% EAT Pref share divi 30*12% Earning to ESH No of shares Existing New 0.3 Total EPS (Highest) (c) The incentive to let other people pay for a good or service, the benefits of which are enjoyed by an individual is known as the free rider problem. In other words, free riding is benefiting from the actions of others without paying.

10 Consumers can take advantage of public goods without contributing sufficiently to their production. The absence of excludability in the case of public goods and the tendency of people to act in their own self interest will lead to the problem of free riding. There is no incentive for people to pay for the good because they can consume it without paying for it. There is an important implication for this behaviour. If every individual plays the same strategy of free riding, the strategy will fail because nobody is willing to pay and therefore, nothing will be provided by the market. Then, a free ride for any one becomes impossible. On account of the free rider problem, there is no meaningful demand curve for public goods. If individuals make no offers to pay for public goods, then the profit maximizing firms will not produce them. If there is no free rider problem, people would be willing to pay for them and they will be produced by the market. As such, if the free-rider problem cannot be solved, the following two outcomes are possible: No public good will be provided in private markets Private markets will seriously under produce public goods even though these goods provide valuable service to the society. (d) Regional accounts provide an integrated database on the innumerable transactions taking place in the regional economy and help decision making at the regional level. At present, practically all the states and union territories of India compute state income estimates and district level estimates. State Income or Net State Domestic Product (NSDP) is a measure in monetary terms of the volume of all goods and services produced in the state within a given period of time (generally a year) accounted without duplication. The Central Statistical Organisation assists the States in the preparation of these estimates by rendering advice on conceptual and methodological problems. In the preparation of state income estimates, certain activities such as are railways, communications, banking and insurance and central government administration, that cut across state boundaries, and thus their economic contribution cannot be assigned to any one state directly are known as the Supra-regional sectors of the economy. The estimates for these supra regional activities are compiled for the economy as a whole and allocated to the states on the basis of relevant indicators Question 6 (a) Statement Showing Cost and Sales for the First Year Annual Production Capacity Production 60,000 units 40,000 units

11 Sales 35,000 units Particulars Rs. Sales Revenue (Rs. 80 * 35,000) 28,00,000 Cost of Production: Rs. 20 per unit 8,00,000 Direct Rs. 15 per unit 6,00,000 Manufacturing Overheads Rs. 15 per unit 6,00,000 Fixed (based on production capacity 60,000 units* Rs. 10) 6,00,000 Cost of Production 26,00,000 Less: Closing Stock (40,000 35,000 = 5,000 units). 26,00,0000*5000/40,000 3,25,000 Cost of Goods Sold 22,75,000 Add: Selling & Distribution Overheads Rs. 3 *35,000 units = 1,05,000 Fixed (Re. 1 * 60,000 units) = 60,000 1,65,000 Cost of Sales 24,40,000 Profit 3,60,000 Statement Showing Working Capital Requirement A. Current Assets Rs. Stock of Raw Materials (Rs. 8,00,000 * 3/12) 2,00,000 Stock of Finished Goods 3,25,000 Debtors at Cost (Rs. 24,40,000 * 3/24) 3,05,000 Cash and Bank 60,000 Total (A) 8,90,000 B. Current Liabilities Creditors for Materials (Rs. 10,00,000 * 4/12) 3,33,333

12 Creditors for Expenses (Rs. 13,65,000 * 1/24) 56,875 Outstanding Wages (Rs. 6,00,000 * 1/12) 50,000 Total (B) 4,40,208 Working Capital Requirement before Contingencies (A B) 4,49,792 Add: Provision for Contingencies (Rs. 4,49,792 * 1/9) 49,977 Estimated Working Capital Requirement 4,99,769 Workings Notes: Purchase of Raw Material during the first year Rs. Raw Material consumed during the year 8,00,000 Add: Closing Stock of Raw Materials (3 months consumption) 2,00,000 Less: Opening Stock of Raw Material Nil Purchases during the year 10,00,000 (b) If average invoice amount is Rs 10,00,000 If discount is Accepted (Rs) Not Accepted (Rs) Payment to Supplier (Rs) 9, ,00,000 Return on investment of Rs9,85,000 for 30 days {Rs 9,85,000 (30/365) 15%} (12,144) 9,85,000 9,87,856 Thus, from above table it can be seen that it is cheaper to accept the discount. (c) Operating risk is associated with cost structure whereas financial risk is associated with capital structure of a business concern. Operating risk refers to the risk associated with the firm s operations. It is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses, which are affected by demand of firm s products, variations in prices and proportion of fixed cost in total cost. If there is no fixed cost, there would be no operating risk. Whereas financial risk refers to the additional risk placed on firm s shareholders as a result of debt and preference shares used in the capital structure of the concern. Companies that issue more debt instruments would

13 have higher financial risk than companies financed mostly by equity (d) The distribution responsibility of the government arises from the fact that, left to the market, the distribution of income and wealth among individuals in the society is likely to be biased and therefore the government has to intervene to ensure a more desirable and just distribution. The distributive function of budget is related to the basic question of for whom should an economy produce goods and services. The distribution function also relates to the manner in which the effective demand over the economic goods is divided among the various individual and family spending units of the society. Effective demand is determined by the level of income of the households and this in turn determines the distribution of real output among the population. The distribution function of the government aims at: redistribution of income to achieve an equitable distribution of societal output among households advancing the well-being of those members of the society who suffer from deprivations of different types providing equality in income, wealth and opportunities providing security for people who have hardships, and ensuring that everyone enjoys a minimal standard of living